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Summary Principles of Economics and Business 1 (all the chapters for the exam)
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This summary includes all the chapters for the exam. 126 pages fully in details explained.
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Product ofJørgen Venberget
Preface
Incentives:
- When and how to use them…
- ...and which incentives to use in a given situation
- “The most important idea in microeconomics”
Supply and demand
The price system
Ch1: The Big Ideas
1 Incentives matter:
- Incentives are rewards and penalties that motivate behavior
- Self-interest is a strong force, as described by Adam Smith in The Wealth of
Nations; The division of labor and specialization
2 Good institutions will align self interest with the social interest:
- If they are aligned, more people will be “pleased” with the results
- Self-interest without the consideration of social interests can cause negative
outcomes, e.g. pollution (absence of the “invisible hand”)
- Sources of power (i.e. governments) can create incentives or change incentives
with taxes, subsidies, regulations, etc.
- Adam Smith: those who pursue their own interest end up promoting the social
interest, as if led by an “invisible hand”
- It is self-interest, as the produced outcome, i.e. social interest, is not part of their
intention or design, but that nevertheless have desirable properties (i.e. farmers and
food production)
1
,3 Trade-offs:
With drugs as an example:
- Safer drugs requires more testing and more resources; it would be safer than if it
were to be released sooner
- The trade-off is to either release less safe drugs that can potentially save/harm
people, or have more people definitely die because the absence of any drug at all
Trade-offs are closely related to opportunity costs:
Opportunity cost:
- The cost/value of the opportunities lost when making a choice
- It is important to be aware of the opportunity costs when you are faced with
trade-offs
Example: the opportunity costs of an academic education is working jobs that you are
unable to do due to time
- By specialising your education you gain the opportunity of having “an edge” in your
field, but you will “lose out” on other specialisations, and the opportunity to make
money earlier by taking on a full-time job
4 Thinking on the margin:
- The benefits and costs of a decision (e.g.: driving faster to save time but running the
risk of being ticketed by the authority)
Margin is another way of reinstating the importance of trade-offs
- Marginal cost (the additional cost of producing a little bit more)
- Marginal revenue (the additional revenue from producing a little bit more)
- Marginal tax rates (the tax rate on an additional dollar of income)
2
,5 The power of trade:
- The real power of trade is the power to increase/improve production through
specialization (Adam Smith)
- If there are low opportunity costs and you improve/increase your production in
your specialization, you will create more value (and demand), that you can use for
trade (more resources to spend)
- Through the division of knowledge, the sum total of knowledge increases and in this
way so does productivity
- Trade allows us to take advantage of economies of scale, the reduction in costs
created when goods are mass-produced
Theory of comparative advantage: when people or nations specialize in goods in which
they have a low opportunity cost, they can trade to mutual advantage
- If the productivity of American business in production of jet aircrafts or designing
high-technology devices increases, so does the demand to trade for textiles or steel
6 The importance of wealth and economic growth:
- Economic growth -> wealth -> more resources -> progress -> better lives -> more
satisfied/happier citizens (not always true)
- Wealth matters, and understanding economic growth is one of the most important
tasks of economies
- People in countries with higher GDP per capita tend to have happier, more satisfied
lives (within a country, people with higher incomes also tend to be a little happier)
7 Institutions matter:
- Stable institutions that can promote progress or make it easier is important for
economic growth
- If there are no incentives, there will not be any progress
- Wealthy countries have lots of physical and human capital per worker and they
produce things in a relatively efficient manner, using the latest technological
knowledge
3
, Entrepreneurs, investors and savers need incentives (good investments) to save and invest
in physical capital, human capital, innovation and efficient organization
- The most powerful institutions for supporting good incentives are
(1) property rights,
(2) political stability,
(3) honest government,
(4) a dependable legal system,
and (5) competitive and open markets
The incentives to produce new ideas is the force that keeps the standard of living from
stagnating.
- Requires a scientific community and the freedom and incentive to put new ideas into
actions
8 Economic booms and busts cannot be avoided but can be
moderated:
- Economic growth is never at a constant pace, and will recede, rise and fall, boom and
bust
- In recessions, wages fall and many people are thrown into miserable unemployment
- Booms and busts are part of the normal response of an economy to changing
economic conditions
- Recessions are not unavoidable, as real shocks such as natural disasters cannot be
controlled or avoided; just mitigated or moderated
- It is important in macroeconomics to understand what/which busts and booms that
can happen to the economy, and what they are caused by
It is also important to establish monetary and fiscal policies that can pick up on and solve
these issues better when they occur (safety nets)
- Monetary and fiscal policies can reduce swings in unemployment and GDP by
providing stimulus to the aggregate demand in a recession
- Important to note, these policies can in some cases make recessions worse and the
economy more volatile
4
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